Volatility is Disruptive, Too

Outsized stock market declines are like accidents on the freeway: they take our attention away from the big picture and refocus it on one narrow issue. We get so fixated on one thing – slumping equity markets – that it is easy to forget that there are second and third order effects to a change in equity market psychology.

Tech stocks bore the brunt of the market selloff on Friday, and will likely do so in any further decline. Since many equities here have higher valuations and better one-year performance than market averages, that’s to be expected. The only notable exception on Friday was Amazon, bolstered by a strong Q4 earnings result the prior evening. But even that outperformance will be tested by a further selloff.

The first notable question, therefore, is how long before we see more mergers and acquisitions among public companies in the Technology sector? Many mega-caps have already announced plans to repatriate and spend their cash hoards. In a period of rising stock prices, M&A is less attractive than buybacks and dividends. But when equity prices hit an air pocket, suddenly lower target company valuations can reverse that calculus. Lower prices also put activists in the hunt, sniffing out companies that should put themselves on the market even if management is reluctant to do so.

Then there is the topic of privately held Tech disruptors that are funded by venture capital. These companies have benefited from a historic level of funding over the past year. At the end of this section is an article from TechCrunch that summarizes the point neatly: last year VCs put $66 billion into “Unicorn” companies worth more than $1 billion. This was 39% higher than 2016.

The bigger these companies get, the more they must rely on public equity valuations as a backstop to their own notional enterprise value. This is not just because many of them will eventually end up in public markets. It is also because the only other exit – purchase by a public company – also requires any transaction to make sense for the purchaser in terms of their own stock market valuation.

The key takeaway is that protracted equity market volatility will force a valuation and strategy rethink for many Tech unicorns. Capital market cycles don’t just apply to stocks. Venture and private capital have them as well. And in many ways the last 5 years have been bubblier in that space than in US Tech sector equities.

This may actually be a hidden positive for many non-Tech sector stocks around the world. Public equity investors have lived under the threat of disruption from well-funded private companies for most of the last 5 years. This has crimped valuations even as near term fundamentals grew stronger. A correction in venture capital valuations and funding may just be the breathing room these old-school companies need to catch up.